The vicious circle of dynamic pricing in the airline industry

Among Renaissance Innovations that dramatically changed airline industries around the world is dynamic pricing.

Now we take for granted that a person sitting next to you on the plane might have paid a fraction of what you paid. However, it was not always this way. Only about 30 years ago, for instance, US airline industry was heavily regulated with almost no price fluctuations. But then the industry was deregulated and the airlines became free to set any prices they like. Like it was the case with some other innovations, dynamic pricing was born out of necessity: major legacy airlines were under intense pressure to compete with low-cost carriers which were undercutting them on prices. However, the casualty of that battle was not the legacy airlines, and all because of a Renaissance Innovation.

In the early 1980s, American Airlines was bleeding due to the invasion of a low-cost competitor People Express which was using flat, low prices far below what American Airlines was charging. In many respects, People Express was similar to numerous low-cost airlines we see today: a single class of seats (economy), extra fees for any service (including a bag of chips) and low, low, low prices, with tickets usually sold out instantaneously. American Airlines could not match these low prices – its cost structure was too high for this. Out of necessity to deal with competition was born a solution: charge different prices to different people, or price discriminate. Typically prices would start low, as low as People Express would offer thus successfully fighting competition. However, the number of seats available at these low prices would be limited, controlled by the so-called yield management system (for some more technical details behind such systems see a teaching note I co-authored at some point). But as the time approached departure, cheap seats would be closed and prices would go up, in the expectation that business customers with high willingness to pay would show up. Thus, American Airlines stayed competitive with low-cost carriers (at least for some portion of demand) while still charging higher average prices. Long story short, in 1987 People Express ceased to exist, in large part due to Renaissance innovation, now known as dynamic pricing.

This old story gave rise to current airline industry practices where dynamic pricing is taken for granted. From the airline industry, it spread to hotels, restaurants, cruise lines, baseball stadiums and other industries. The yield management system of American Airlines which dominated People Express was spun off into a separate company known as Sabre Holdings which now far exceeds American Airlines in market capitalization. The idea behind dynamic pricing is well-explained by the Renaissance Innovation logic. Airlines face the fundamental risk of mismatch between demand and supply, which is driven by the price of the ticket, and the corresponding risk of unused capacity. The cause of this risk is a huge variance in the customers’ willingness to pay: if the price is set too high, there is a risk of not filling up capacity, which is worthless after plane’s departure. If the price is set too low, the airline does not cover its cost of operation. The answer is to vary prices dynamically, based on the length of the trip, the day of departure, round-trip purchase etc., anything that can separate business and leisure travellers. This practice truly revolutionised the otherwise pretty stagnant industry, and airlines attribute billions of dollars in profit to dynamic pricing. Most airlines have not been making money lately, but things could have been much worse…

Of course, dynamic pricing is now much trickier than it used to be: consumers became aware of airline’s practices and, with the help of websites like www.farecast.com (now bing.com/travel) started predicting what will happen with prices and time their purchases accordingly. The problem here is that it is very tempting for an airline to start discounting tickets very close to the departure to fill up the plane. Of course, consumers are not stupid and notice this, and start delaying their purchases. In a recent paper based on the airline ticket data, we find that about 30% of consumers behave in this way, trying to trick the dynamic pricing systems. Are such strategic consumers always bad for the airlines? And is there a solution to break this vicious cycle? Yes, but this will be a subject for another post.

Serguei Netessine is the Timken Chaired Professor of Global Technology and Innovation at INSEAD and the Research Director of the INSEAD-Wharton alliance.